Choices and consequences - prescription medication - Do Rx Drugs Cost Too Much?

It is almost never possible to justify a high price for anything; .once people agree that the price is high, they almost always agree that there must be something wrong. When it comes to prescription medications, however, I'm not sure that I would agree that the price is high.

A full page ad from a discount drugstore chain in last month's Philadelphia newspapers gave the prices for the 50 most common prescriptions. A few prices were a little above $100, but the great majority were less, and for some generic antibiotics the price was below $10. Last month I flew from Philadelphia to Boston and returned in the same day; my airfare was $506.50. Which price was high? Obviously, the answer to the question depends on the standard of comparison - which leads to the inescapable conclusion that the only thing we can be sure of is that no one can prove absolutely whether drug prices are high or not. We can only offer opinions, and those opinions depend on what we use as the basis of comparison.

For instance, we might compare drug prices in the U.S. with those in other countries. As my colleague, Patricia Danzon, has shown,(*) the prescription drugs look uniformly expensive here only if comparisons are made selectively, not if we compare a broad representative sample of drugs using proper price indexes. Another standard for comparison is to consider the profit rates of drug companies with those of other firms. Compared to Microsoft, drug company profits as a percentage of revenues or as a return on equity look low.

They do look somewhat higher than the typical accounting number for a Fortune 500 firm, but if we calculate profits correctly by including investment in R&D as part of equity capital and compare drug companies with firms in equally risky situations, as economist Henry Grabowski of Duke University has shown, the differences are small, if not nonexistent. Moreover, an ideal economy is not one in which consumers are happy because all firms earn profits that are equal to or below average. In addition to being required by logic, above-average profits for some firms in a market economy serve the useful function of signaling to firms and investors that consumers appear to want more of the same kinds of products that currently yield those profits.

For me, however, both as an analyst and a consumer, these comparisons are not the relevant ones. If drug prices are too high, we know the cause: Governments grant patents - legally protected monopolies - to new drugs, entitling their manufacturers to government-enforced protection from competition for years, even if there is some other company that could and would produce the same drug and sell it at some lower price. Patents are not a perfect shield, but they do help to protect higher prices and higher profits than would have occurred in their absence. Even in this cynical age, however, we do not believe that patents exist solely to provide corporate welfare; instead, they serve as devices to encourage research and development of innovative and useful products. Abolish or limit patent protection, and we would have cheaper drugs, but fewer of them.

The real question then is whether the higher profits patents permit do indeed bring forth the ideal supply of new products. That ideal supply is defined in part by comparing the total benefits expected from a potential new product and its expected cost. If the former exceeds the latter, we will benefit from having a new product, even if the prices needed to cover its cost are "high." The relevant next question then is: Are current patent policies and the prices that follow from them calling forth new products whose benefits exceed their cost to the maximum extent?

The larger policy question is even more complex: Is the net benefit from the last new product that just cleared the profit hurdle greater or less than the net benefit from greater use of existing products that would occur if their prices were lowered?

I know what the first research questions ought to be: If prices were lower, what new products would not emerge? And, if prices were lower, how much additional use of drugs would there be and how much is that use worth? I also know that no one, either inside or outside the pharmaceutical industry, knows the answers to these questions - which means in turn that no one can claim to know whether prices are too high (justifiably or not).

One way to get some clues as to whether drug prices are too high is to imagine the consequences if they were lowered. I will rule out government price-setting as a method for price reduction, either for retail sales or in some universal national health insurance plan. Neither form of state intervention seems politically plausible at the present time.

One way to get prices down, at least for a larger part of a product's life cycle, would be to shorten the period of patent protection or, through compulsory licensing, weaken the patent shield in some fashion. We know what the qualitative effect of such a change would be: fewer new products, and especially fewer new products for conditions for which the market is intrinsically small (the so-called "orphan" drugs) or fewer new products that require long periods of development in which investors' capital is at risk. There may be better ways to reward and create incentives for new research - some economists, for instance, have suggested up-front prizes for good discoveries - but so far none has passed the laugh test.

Consider another way to lower prices: Require sellers of drugs in the U.S. to charge the same wholesale price as they charge in the rest of the world. This would cause prices to be higher abroad rather than lower here and lose international business for American drug companies and their workers. In any case, the effect of such a rule would be to reduce the total revenues the company can collect for its drug, since the reason it sells for less abroad is that if the price charged is considered too high, the foreign customer (usually a government or government-regulated health plan) is more willing to forego the American product for a lower-quality alternative. There is, after all, no reason to assume that drug companies charge or accept prices abroad that are lower than what that market will bear, and the thought that they should ally with our government to wring yet higher prices out of foreign markets seems to me to be a mercantilist (and political) delusion. The punch line is that if drug companies are forbidden to use price discrimination in ways that bring in foreign sales so they can maximize their revenues, some drugs will not be brought to market - since the extra revenue from price-discounted foreign sales can be the difference that puts a product's net revenue over the top.

We all wish we could have good drugs cheaper, both now and in the future. In our constrained world, however, we have to choose: We can have more good drugs or cheaper drugs, but not both.

If we had enough information, we might be able to tell whether, compared to what we would otherwise get, we might be willing to give up some brand new products in return for a somewhat lower price for recently introduced products. But, since we most certainly do not have that kind of information and are unlikely to get it without a major analytical effort, we need to be careful in advocating that something be done now about the high price of drugs.

What we wish for might just come true, but some of the consequences may be unintended and undesirable.

Mark Pauly is a professor, health care systems, public policy and management, insurance and risk management and economics, with the Wharton School, University of Pennsylvania in Philadelphia.

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